Since talks were initiated there in 2001, the city of Doha in Qatar has become synonymous with the World Trade Organisationâs ineffectual attempts to lower global trade barriers. But a meeting of the Gulf Co-operation Council states in Qatarâs capital earlier this month could lead to a more positive association.

The summit may come to be remembered as the moment when the six countries took a decisive step towards independent monetary policy, by drawing up a roadmap for a common monetary authority.

Of the six, Bahrain, Oman, the United Arab Emirates, Qatar and Saudi Arabia all have currencies pegged to the US dollar. Kuwait dropped its peg to the greenback in May last year, reverting to a basket of currencies.

The pegs have forced the Gulf states to cut rates in line with the US Federal Reserve, even though the inflationary challenges they face call for a tighter, not looser monetary stance. The peg has also forced the value of Gulf currencies downward at a time when they should have been strengthening, according to Dubai-based HSBC economist Simon Williams.

He said: “The shortcomings of the dollar peg are pronounced. It just doesn’t makes sense for one of the world’s fastest growing economies to leave the value of its currency and its interest rate decisions shackled to the US.”

A sixfold rise in oil prices in as many years has triggered an economic boom in the Middle East, with the International Monetary Fund calculating annual GDP growth in the region to be more than 5%. But inflation has also shot up.

Monthly data available from relevant government agencies show that all GCC countries except Bahrain have suffered double-digit inflation this year, while IMF data shows the Middle East experienced the highest average inflation rate of all global regions last year, at 10.4%. This year it is forecast to exceed 11%.

Middle East countries without interest rate flexibility are only able to curb rising prices by introducing taxes, capping rents and subsidising basic commodities. The first of these measures may dent the attraction of tax-free salaries and spending for expatriate workers, but it is a logical step for the region, according to economists.

The UAE intends to introduce a 100% tax on luxury goods by 2012, while value added tax in some form is also likely to hit the region in the next few years.

Stealth taxes, such as road toll charges for motorists in Dubai, are increasing. And as the dollar has plunged in value, taking the region’s currencies with it, so goods have become relatively more expensive. But the region’s growth appears to be enough of a draw to keep bankers coming. A recent poll on Financial News’ website showed readers thought Dubai was a more attractive destination than New York or Shanghai.

Inflation has also meant that investments in property are booming, despite recognition that it was the bursting of a housing bubble that sparked the US downturn. In response, the United Arab Emirates and Oman have introduced ceilings on rent rises, while Qatar has frozen rental increases for two years.

A report by property services firm CB Richard Ellis last month said Dubai rents leapt 30.7% in the 12 months to March 31, making the city the 10th most expensive worldwide.

Nick Fullerton, managing director of money broker FC Exchange, said: “The dirham is relatively cheap. If it did strengthen as a result of depegging, overseas investors might not find property such an attractive prospect.”
Rising food and oil prices in the Middle East have contributed to inflationary problems, but have been easy political targets for subsidies as social tensions loom.

While the limitations have led to calls for the region to depeg from the US dollar and for a revaluation of currencies to combat inflation, US Treasury Secretary Henry Paulson, in a visit to the Gulf at the start of this month, said depegging was a sovereign matter and would not on its own fix inflation.

Benoit Anne, an emerging markets currency strategist at Merrill Lynch, said. “The revaluation or de-pegging of currencies will not solve the problem but it is a prerequisite to tighten monetary policy. It is a necessary but not sufficient condition for addressing inflation.”

Analysts have disagreed on the extent and timing of any action as policymakers have sent conflicting signals over their intentions.

While Qatar’s finance minister in May dismissed claims made by Merrill Lynch that the country could soon depeg its currency, an economic adviser to Qatar’s emir said days later he was working to convince the government otherwise.
Anne, who worked as an economist at the IMF in the early 2000s, said there was no relationship between the scale and frequency of comments on revaluation and the likelihood of an exchange rate regime change.

However, Williams said: “The case for currency reform is strong but we’re unlikely to see any adjustment in the next 12 months. I don’t sense that gulf leaders are persuaded by the arguments for change and there is a deep preference for joint rather than unilateral action, suggesting little change to the status quo.”

Along with Qatar, the UAE is considered the most likely candidate for a dollar de-peg.

One option that would stop short of full revaluation is to peg to a basket of currencies, in a manner similar to Kuwait, according to Deutsche Bank senior regional economist Caroline Grady, who expects Qatar and UAE to do this before the end of the year as a means to gradually reforming monetary policy.

But Matt Vogel, head of emerging markets research for emerging Europe, the Middle East and Africa at Barclays Capital, said Kuwait’s decision last year to sever its dollar peg and return to the basket peg has failed to solve a critical problem for all pegged currency regimes, namely a lack of monetary policy instruments.

He said policymakers would thus be disinclined to revalue to deal with a wide range of inflationary factors, some of which had nothing to do with dollar weakness.

Khalid Abdulla-Janahi of Bahrain-based Ithmaar bank last month called for revaluation of between 30% and 40% across the Gulf. A revaluation of that size would effectively mean Middle East countries lose substantially given the scale of their dollar-denominated assets.

Uncertainty has fuelled speculation and volatility. This led to monetary inflation in the UAE in November, as investment inflows added $25bn (€16bn) to the country’s capital reserves, almost three times the level of a year before and equivalent to 12.4% of GDP.

The inflows followed comments by the central bank governor in Asia hinting at a change in foreign exchange policy.
Speculation also caused a spike in Qatar’s central bank reserves in March. Inflows rose fivefold year-on-year to $4.2bn.

Grady said: “Central bank reserve inflows in the two countries had been pretty flat. A continuation of the level of inflows seen during recent months would be extremely negative for monetary inflation.”

But Middle East governments have been better able to control the flood in oil money, which they used to spur the development of the region’s financial sector. Bank balance sheets have swelled and lending to the private sector has increased, notably in Qatar, to meet demand for credit underscored by the existence of negative real interest rates.
However, that credit growth has driven domestic demand, exacerbating inflation.

The growth of the six investable stock markets in the Gulf has helped to mop up this excess liquidity, although some investors remain wary after their collapse at the start of 2006. The pipeline for initial public offerings in the region for the rest of this year stands at more than $10bn, according to data provider Zawya IPO Monitor.

Issuance of sukuks, Islamic bonds that offer coupon profits instead of coupon interest, is also flourishing. The global market, which is centered in the Gulf, has grown 15-fold to more than $60bn in the past decade, according to Standard & Poor’s, which said it expects it to expand by 40% to $100bn in the next few years.

But significantly there are also markets in local currency sukuks.

Gary Hawkins, head of emerging markets trading for emerging Europe, the Middle East and Africa at BarCap, said: “The local currency sukuk market started because people realised that there are places to put liquidity that was previously sitting on domestic banks’ balance sheets. There is great appetite for these deals.”